Research: CEOs with Diverse Networks Create Higher Firm Value

Executive Summary

Research has shown that firms benefit when their CEOs have strong networks. A new study explored that idea by looking at whether the diversity of a CEO’s network affects their firm. Researchers used BoardEx data to examined a sample of 1,212 CEOs who led S&P 1500 firms between 2000 and 2010. They analyzed each CEO’s social networks by documenting their school ties, work ties, and leisure social ties (for example, clubs and charities) in the past. They found that CEOs with strong connections to people of different demographic backgrounds and skill sets created higher firm value. They also found that this greater firm value came from better corporate innovations and successful diversified M&As. Their results suggest that the diversity of leaders’ social networks is a key ingredient in how they grow their companies.

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Leaders today hear a lot about the importance of having good networks. For example, firms with better-connected CEOs can obtain cheaper financing, and firms with well-connected board directors see better performance. We wanted to explore whether the diversity of CEOs’ networks might affect their firms.

Our study, published in the Journal of Corporate Finance, found that CEOs with strong connections to people of different demographic backgrounds and skill sets create higher firm value. We also found that this greater firm value comes from better corporate innovations and successful diversified M&As. Our work suggests that the diversity of leaders’ social networks is a key ingredient in how they grow their companies.

Using BoardEx data provided by the Center for Corporate Performance, we examined a sample of 1,212 CEOs who led S&P 1500 firms between 2000 and 2010. We analyzed each CEO’s network by documenting their school ties, work ties, and leisure social ties (for example, clubs and charities) in the past. These connections had to be at least senior managers or higher positions to be considered.

More on our method

Following Fracassi (2016), we identify a school tie between two individuals if they went to the same school and graduated within three years of each other with the same master’s or doctoral degree. The restriction on graduation year and degree is to maximize the probability that the individuals met as a result of shared education. Work ties exist if two individuals worked in the same company. Leisure social ties are identified if two individuals maintain membership in the same country club or serve the same charity, university, government, military, or other nonprofit association.

To measure the diversity of their networks, we aggregated six factors — gender, nationality, academic degrees, majors, professional expertise, and global work experience — into a single diversity index using common factor analysis, a statistical tool that extracts the maximum amount of common variations of the six different components. We measured their firm’s value by Tobin’s Q, a ratio between market value of assets to book value of assets.

To estimate the effect of a CEO’s social network’s diversity on their firm’s value, we used ordinary least square regression models to control for other variables that could potentially change firm value, such as firm size, profitability, financial leverage, investment intensity, and corporate governance.

Our estimation results implied that a CEO who was diversely connected (at the 75th percentile of our diversity index) improved Tobin’s Q by 0.017, compared with an average CEO (at the 50th percentile). And a CEO who was less connected (at the 25th percentile) experienced 0.025 lower Tobin’s Q than an average CEO. To translate the economic magnitude of this: A 0.017 increase of firm value is equivalent to an $81 million increase in market capitalization for a median-size firm in our S&P 1500 sample. Given that the median level of CEO pay of S&P 1500 firms was about $5 million during the sample period, a diversely networked CEO generated an approximately sixteenfold firm market value increase relative to their compensation.

We also performed an event-study analysis to examine whether the market was more favorable to newly appointed CEOs when they had a more diverse network than their predecessors. After carefully matching a control group that shared similar firm and CEO characteristics with our testing group, we found that firms whose new CEO had a more diverse network than their predecessor experienced positive and significant short-run stock market reactions (measured by announcement cumulative abnormal returns, or the sum of stock returns over several days after the announcement of CEO appointment). By contrast, firms whose new CEO had a less diverse network than their predecessor experienced significantly lower announcement cumulative abnormal returns.

We had to address some challenges in interpreting our results. For example, perhaps the effect we found was being driven by the size of a CEO’s network, not its diversity. To rule this out, we controlled for network size throughout all tests. Another potential concern was reverse causality — perhaps better-performing firms allow CEOs to expand their networks to a larger and more diverse group of people. To address this, we used instrumental variables to capture (1) the genetic diversity of CEOs’ countries of origin and (2) the demographic diversity of their undergraduate institutions. We considered these two variables to be good predictors for a CEO’s network diversity, as they reflect the deep-rooted social, cultural, psychological, physiological, and institutional characteristics that may shape CEOs’ mindsets toward diversity — and they would not be influenced by firm characteristics. Using these two variables to measure network diversity, we saw the same results: Greater CEO network diversity was associated with greater firm value.

To further establish causality, we ran a quasi-natural experiment to see what happens when the diversity of a CEO’s social network changes. We gathered data from BoardEx on when someone in a CEO’s network died or retired, as this would change the heterogeneity of their network. We found that one to two years after a CEO’s network is shocked and becomes more diverse, their firm’s value goes up. The findings confirmed a significant within-firm improvement in firm value due to increased network diversity.

But why does a diverse social network enhance firm value? Our task then turned to understanding the mechanisms driving this effect. The literature on diversity suggested a few hypotheses. One was that a more diverse network would give CEOs access to diverse sets of knowledge, which can lead to novel ideas and willingness to tackle innovative projects. If this was the case, then we would expect the firm to demonstrate greater innovation. And we did find strong evidence that firms of CEOs with more-diverse connections tended to have higher-quality patents, as measured by citation counts associated with the patents and the amount of new technologies generated through their innovation process.

The second hypothesis we considered is that heterogeneous social ties would increase a CEO’s ability to obtain a network of foreign contacts and identify good business opportunities in other industries. In this case, we’d expect diversely connected CEOs to be successful in executing diversifying and cross-border M&A. To test this, we examined market reactions around the announcement of mergers. We found that the level of network diversity of the acquirer CEO was positively associated with stock market reactions when they took over a target in a different industry or in a different country. (CEO network diversity did not matter when the target firms were in the same industry or country.)

Our findings have broad implications. Today’s CEOs require expansive knowledge to innovate and respond to increased competitive pressure. Although acquiring knowledge can be costly, our findings suggest that the more diverse the social networks of the CEO area, the greater the growth opportunities are for the firm through exposure to different types of information and knowledge. Our results should encourage shareholders to consider how diversity of the social networks of upper management and board members can add value to the firm, given the changing face of the workforce and increasing global competition.

Second, increased diversity in the workplace is a central issue of debate. Some claim that firms are pressured to hire minorities for ethical rather than profitability reasons, while others argue that firms should strive to have talented employees with a variety of experience, knowledge, and cultural backgrounds, as they help firms succeed in a global marketplace. Through the lens of CEOs’ connections in the labor market, our findings offer academic evidence that diversity and heterogeneity are indeed tangible assets that increase profits.

While the current study provides empirical justification for the value of forming heterogeneous social ties, these results do not imply that CEOs should maximize their social network diversity without considering the costs of forming and maintaining multiple types of ties. We cannot ignore the potential for downsides. For instance, conflicts driven by diversity among groups may also negatively affect performance. CEOs with diverse social ties may also be distracted from acting in shareholders’ best interests because they are too concerned with social interactions.

But from our research, the takeaway is that the benefit of a diverse social network on average outweighs the cost.

Yiwei Fang is an assistant professor in Finance in Stuart School of Business at Illinois Institute of Technology. Her research interests are in the areas of corporate finance, social networks, and financial institutions. Her work has appeared in leading journals such as Journal of Corporate Finance and Journal of Banking and Finance, among others.

Bill Francis is the Warren H. and Pauline U. Bruggeman Distinguished Professor of Finance in Lally School of Business at Rensselaer Polytechnic Institute. His research interests are in the areas of financial institutions and corporate finance. He has published numerous articles in reputed finance and economic journals such as the Journal of Financial Economics, the Review of Financial Studies, the Journal of Financial & Quantitative Analysis, among others.

Iftekhar Hasan is the E. Gerald Corrigan Chair in International Business and Finance at Gebelli School of Business and co-director of the Center for Research in Contemporary Finance. His research interests are in the areas of financial institutions, corporate finance, capital markets, and emerging economies. His work has appeared in leading journals such as the Journal of Financial Economics, the Journal of Financial & Quantitative Analysis, and the Strategic Management Journal, among others.